What’s Luck Got To Do With It?

Posted on January 21, 2014

“Luck is what happens when preparation meets opportunity.” - Seneca

Nestled on 22 acres in the beautiful woods of Westport, CT, Bridgewater Associates, the world’s largest hedge fund, plays home to 1,200 employees and over $100 billion in institutional assets. Clients include some of the largest pensions, endowments and sovereign wealth funds across the globe. Founded in 1975, Bridgewater’s track record has been built over nearly four decades. Simply put, it is one of the most successful investment firms of all time.

Bridgewater’s founder, Ray Dalio, is an eccentric but likeable personality who isn’t afraid of breaking from convention if it means doing what he believes is the right thing. He has been labeled “the Steve Jobs of investing” by some, and TIME magazine includes him amongst the 100 most influential people in the world. In addition to his track record as an investor, he is well known for his 123-page personal manifesto, simply titled Principles, which he self-published in 2011. He also received a lot of recognition for his 2008 essay, How The Economic Machine Works, which was recently turned into a 30-minute animated video that is definitely worth checking out.

Early on in his career a series of economic and market-related shocks led Dalio to develop a modus operandi to always expect surprises. He came to believe that even the smartest investor couldn’t predict the future with any certainty, but could only construct a portfolio that had the highest probability of performing well in a variety of possible outcomes. The best way to do this, according to Dalio, was to combine a variety of asset classes that possess different “environmental biases”, meaning they perform well in different types of growth and inflationary environments. He believed that the traditional, equity-heavy portfolio was akin to taking a huge bet on a particular set of economic and inflationary outcomes, and that by adding in assets such as long-dated Treasuries, commodities, inflation-linked bonds and gold in risk-adjusted sizes one could produce more consistent returns over a long period of time without having to correctly predict what type of environment the future held.

In the mid-90’s these beliefs led Dalio, along with his two other Chief Investment Officers, to create what they called the “All Weather” portfolio. According to the story as told by Bridgewater, All Weather was the result of distilling decades of learning into a single portfolio and was the best allocation strategy they could build without any requirement to predict future conditions.

All Weather grew out of Bridgewater’s effort to make sense of the world, to hold the portfolio today that will do reasonably well 20 years from now even if no one can predict what form of growth and inflation will prevail.

The original impetus for All Weather was Ray’s desire to place a significant portion of his personal wealth into a family trust and invest it in an asset allocation mix that he believed would prove reliable long after he was gone. But what started as a personal portfolio was quickly rolled out as an institutional offering and today exists as one of Bridgewater’s two primary funds. As of today, Dalio’s family trust is still 100% invested in the All Weather portfolio. Now for the shocker…according to a variety of media reports, All Weather suffered a 3.9% loss in 2013.

Let that sink in for a minute. Famed investor Ray Dalio, a seasoned veteran of 40 years, posted a 3.9% loss in his “All Weather” portfolio in a year when the US stock market rose over 30%. How could something like that happen?

To help answer that question we turn to Howard Marks, who was co-founding Oaktree Capital Management around the time Dalio was creating All Weather. Marks recently penned a thought provoking memo to his clients about the role of luck in investing. He frames the plight of every investor rather simply:

We arrange our lives – or, in investing, our portfolios – in expectation of what we think will happen in the future. In general, we get the desired results if future events conform to our hopes or expectations, and less-desired results if they don’t. The point is that we assemble our portfolios, and future events determine whether our performance will be rewarded or punished.

He goes on to further explain why this is such a big problem, even for the likes of Ray Dalio:

…in investing, it’s hard to know what will happen and impossible to know when it will happen. Many things influence performance other than (a) investors’ hard work and skill and (b) the market’s dependable discounting of information about the future. Luck – randomness, or the occurrence of things beyond our knowledge and control – plays a huge part in outcomes.

Investment success isn’t just a question of whether the investor put together the “right” portfolio, but also whether it encountered a beneficial environment. Thus being successful requires a significant degree of luck. No one gets it right every time. But the skillful investor is right more often, over a long period of time, than an assumption of randomness would permit.

It occurs to us that even in constructing All Weather, a portfolio that was not supposed to be dependent on any particular environment in order to perform well, Dalio and company were still applying a set of assumptions about the future. Even though they were not attempting to be precisely correct about every little detail, they assumed that long-standing inter-asset class relationships would continue to exhibit historical tendencies. They believed they would at least be generally correct in every environment. Then 2013 came and all the historical relationships went out the window. Developed market stocks decoupled dramatically from their emerging counterparts, gold collapsed in the face of an exploding monetary base on the back of QE-infinity, commodities trended lower even as global economic expectations improved and bond yields shot higher despite a persistently loose Fed and lack of inflation. Even Bridgewater’s All Weather portfolio is subject to risk as defined by Elroy Dimson of the London Business School: “Risk means more things can happen than will happen.”

Investment approaches built on the same fundamental principles as All Weather have gained in popularity over the past two decades and have been adopted by a large percentage of investors in the institutional space. Retail investors, while slower to catch on, have also been abandoning traditional stock/bond portfolios and embracing this style of investing in increasing numbers. We don’t know exactly how All Weather was positioned through the course of 2013, but the strategy’s performance illustrates the truth observed by Howard Marks, that the occurrence of things beyond our knowledge or control plays a huge part in outcomes – and no one gets it right every time. In other words even Ray Dalio can get unlucky from time to time.

Last year any amount of diversification beyond US equities amounted to nothing less than a kiss of death. Literally no other asset class added value, and in fact several of them offered up significant losses. Our portfolios certainly felt the pain of this trend given our Diversification 2.0 methodology. But does 2013’s performance mean that our investment principles should be abandoned in favor of a portfolio comprised exclusively of US stocks? We think not, as that would be akin to driving a car by looking exclusively in the rear-view mirror. At the end of their paper telling the story of All Weather, Dalio and company make the following statement: “Bridgewater accepts the fact that they don’t know what the future holds, and thus chooses to invest in balance for the long run.” We agree with this sentiment and continue to believe that a widely-diversified asset allocation is prudent over the long-term for most investors despite the occasional “unlucky” streak that will inevitably occur from time to time.

Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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